Investing Articles |
Weathering a Stock Market Correction
A period of falling stock prices — a correction or bear market — is defined as a time where major market indexes drop at least 10%. When stock prices are falling, some investors find themselves trapped in a vicious emotional cycle. Fear of losing money can lead to a quick, poorly planned investment decision.
Investors who have prepared their portfolio for occasional market drops generally are better able to manage their emotions when stock prices head south.
Be Prepared: Assess Your Portfolio Now
To manage your fear of a market correction, take time to review your portfolio. Are all your investments in stocks or stock mutual funds? Do you own just one stock mutual fund? Have you invested in only a few high-flying stocks?
Remember, all investments involve risk. As a long-term investor, you can afford to weather short-term price changes. But you can also make the long journey a little more enjoyable by taking a few steps to help protect your portfolio. Here’s a short list of some risks you face as a holder of stocks or stock mutual funds, and some ideas about how to help manage the risks in your portfolio.
Address Your Risks One By One
Market Risk
Market risk is common to all investments. If stock prices fall by 10%, market risk says your stocks or stock mutual funds are likely to drop in price as well. You can help manage market risk to stocks by allocating part of your portfolio to other assets, such as bonds or bond mutual funds and Treasury bills or money market funds.* When stock prices decline, it’s possible that a rise in your bond or money market investment may help cushion the fall.
*An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
Under diversification.
If you only own a couple of stocks, your portfolio is extremely vulnerable if one suffers a big decline. Also, it’s important that each stock in your portfolio be in a different industry group. Owning eight computer-related stocks will do you little good if the prospects dim for the computer industry.
In addition, you can help manage risk by holding a few stock mutual funds with different investment objectives.
Volatility.
This is less of a concern for the long-term investor. Someone who is investing for retirement in 30 years should not be too concerned if the investment bounces around from one day to the next. What is important is that the investment has the potential to perform up to expectations in the long term. You can help manage volatility risk by investing the money you may need in the next five years in a more conservative investment. You can be more aggressive with the money you earmarked for use in 15 to 20 years, if that would be suitable for you.
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This chart shows how a $10,000 investment would have been affected by missing the market's top-performing days over the 20-year period from January 1, 1989, to December 31, 2008. For example, an individual who remained invested for the entire time period would have accumulated $50,455, while an investor who missed just 10 of the top-performing days during that period would have accumulated only $26,006. This hypothetical example does not represent the performance of a specific investment.
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Value Investing
Downside Risk.
Owning a stock that drops 50% in value can have a devastating impact on a portfolio. The next stock you own would have to climb 50% just to offset that initial decline. You can potentially manage downside risk by not owning stocks that trade with price/earnings ratios above 20. When the stock market does retreat, these expensive stocks have the potential to fall the furthest.
Look for issues with more reasonable P/E ratios — often called value stocks — that may pay dividends more often than stocks with higher P/E ratios. Mutual fund investors should look for funds that invest in similar types of stocks.
Liquidity Risk.
You may be able to reduce liquidity risk by focusing on large, actively traded companies such as the issues included in the S&P 500. Generally, mutual fund investors do not have to worry about liquidity risk. But if you invest with a small mutual fund company, make sure you understand the rules about withdrawing funds before sending money.
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If the prospect of the market falling scares you, consider this chart. In the past 25 years, the S&P 500 has recorded only five years of negative returns, and only once has the index finished on the negative side for three consecutive years. Keep in mind that investors cannot invest directly in an index. Past performance cannot guarantee future results. Source: Standard & Poor’s. Stocks are represented by Standard & Poor’s Composite Index of 500 Stocks, an unmanaged index generally considered representative of the U.S. stock market. Data is for the period ended December 31, 2008. Past performance does not guarantee future results. |
Take A Cyclical View: Market Declines Can Be Healthy
It’s important to remember that periods of falling prices are a common part of investing in the stock market. While some investors will use a variety of trading tools, including individual stock and stock index options, to help hedge their portfolios against a sudden drop in the market, perhaps the best move you can make is managing your overall risk position.
One risk that some investors may be exposed to is the risk of is falling short of a long-term financial goal.Investing too conservatively may contribute to not reaching an accumulation target. Remember thatdespite several down cycles, stock prices as measured by the S&P 500 have risen steadily over time. The S&P 500 has posted a 9.68% average annual rate of return for the period from December 31, 1925, to December 31, 2008.** Of course, past performance is not indicative of future results. Investors cannot directly purchase an index. Being too conservative and avoiding stocks could limit your portfolio’s return.
**Source: Standard & Poor’s. Stocks are represented by Standard & Poor’s Composite Index of 500 Stocks, an unmanaged index generally considered representative of the U.S. stock market. Based on the period from December 31, 1925, to December 31, 2008. Investors cannot invest directly in an index. Past performance is not indicative of future returns.
Points To Remember
- A bear market is defined as a period where major market indexes drop at least 10%.
- If stock prices are falling, market risk says that your stocks or stock mutual funds are likely to decline as well. You can help manage this risk by allocating part of the assets in your portfolio to other assets such as bonds.
- Manage under diversification risk by investing in a variety of stocks in different industry groups, or by investing in a few stock mutual funds with different investment objectives.
- Volatility risk is a consideration, but the longer your time horizon the less you should be overly concerned with day-to-day price fluctuations.
- The downside risk with stocks that have high price/earnings ratios is great. You can help manage downside risk by investing in stocks with reasonable P/E ratios and in mutual funds that concentrate on similar issues.
- Investing in large, actively traded stocks may help manage liquidity risk. Mutual fund investors should understand the rules of withdrawing funds before sending money.
